An Introduction to Capital Structure

You often hear corporate officers, professional investors, and investment analysts discuss a company's capital structure. You may not know what a capital structure is or why you should even concern yourself with something that sounds so technical but rest assured that the concept is extremely important because it can influence not only the return a company earns for its shareholders but whether or not a firm survives in a recession or depression. Sit back, relax, and prepare for a basic introductory course on capital structure and why it matters to you and the components within your investment portfolio!

Capital Structure — What It Is and Why It Matters

The term capital structure refers to the percentage of capital (money) at work in a business by type. Broadly speaking, there are two forms of capital: equity capital and debt capital. Each type of capital has its benefits and drawbacks, and a substantial part of wise corporate stewardship and management is attempting to find the perfect capital structure regarding risk/reward payoff for shareholders. This is true for Fortune 500 companies and for small business owners trying to determine how much of their start-up money should come from a bank loan without endangering the business.

Let's take a moment to look at these two forms of capital a bit more closely.

Equity Capital

Equity capital refers to money put up and owned by the shareholders (owners). Typically, equity capital consists of two types:

Contributed capital, which is the money that was originally invested in the business in exchange for shares of stock or ownership.

Retained earnings, which represents profits from past years that have been kept by the company and used to strengthen the balance sheet or fund growth, acquisitions, or expansion.

Many consider equity capital to be the most expensive type of capital a company can utilize because its "cost" is the return the firm must earn to attract investment. A speculative mining company that is looking for silver in a remote region of Africa may require a much higher return on equity to get investors to purchase the stock than a firm such as Procter & Gamble, which sells everything from toothpaste and shampoo to detergent and beauty products.

Debt Capital

The debt capital in a company's capital structure refers to borrowed money that is at work in the business. The safest type is generally considered long-term bonds because the company has years, if not decades, to come up with the principal while paying interest only in the meantime.

Other types of debt capital can include short-term commercial paper utilized by giants such as Wal-Mart and General Electric that amount to billions of dollars in 24-hour loans from the capital markets to meet day-to-day working capital requirements such as payroll and utility bills. The cost of debt capital in the capital structure depends on the health of the company's balance sheet — a triple AAA rated firm is going to be able to borrow at extremely low rates versus a speculative company with tons of debt, which may have to pay 15 percent or more in exchange for debt capital.

Aside from equity and debt capital, there are other forms of capital such as vendor financing where a company can sell goods before they have to pay the bill to the vendor, that can drastically increase return on equity but don't cost the company anything. This was one of the secrets to Sam Walton's success at Wal-Mart. He was often able to sell Tide detergent before having to pay the bill to Procter & Gamble, in effect, using PG's money to grow his retailer.

In the case of an insurance company, the policyholder "float" represents money that doesn't belong to the firm but that it gets to use and earn an investment on until it has to pay it out for accidents or medical bills, in the case of an auto insurer. The cost of other forms of capital in the capital structure varies greatly on a case-by-case basis and often comes down to the talent and discipline of managers.

Seeking the Optimal Capital Structure

Many middle-class investors believe that the goal in life is to be debt-free. When you reach the upper echelons of finance, however, that idea is less straightforward. Many of the most successful companies in the world base their capital structure on one simple consideration — the cost of capital.

If you can borrow money at 7 percent for 30 years in a world of 3 percent inflation and reinvest it in core operations at 15 percent, you would be wise to consider at least 40 percent to 50 percent in debt capital in your overall capital structure particularly if your sales and cost structure are relatively stable.

If you sell an indispensable product that people simply must have, the debt will be a much lower risk than if you operate a theme park in a tourist town at the height of a boom market. Again, this is where managerial talent, experience, and wisdom comes into play.

The great managers have a knack for consistently lowering their weighted average cost of capital by increasing productivity, seeking out higher return products, and more. This is the reason you often see highly profitable consumer staples companies take advantage of long-term debt by issuing corporate bonds.

To truly understand the idea of capital structure, you need to take a few moments to read about the DuPont model to gain an insight into how capital structure represents one of the three components in determining the rate of return a company will earn on the money its owners have invested in it. Whether you own a doughnut shop or are considering investing in publicly traded stocks, it's knowledge you simply must have if you want to develop a better understanding of the risks and rewards facing your money.